Startup-Investor Negotiations MohammadReza Farahi About me MohammadReza Farahi Finance Advisor at Rahnema Ventures Besides academic education in finance in France and Spain, he has a great experience of valuation and investment affairs with tens of startups in Rahnema ventures. Notice All rights reserved. This document is an exclusive property of Charkh Academy . No part of it may be reproduced or quoted, in any form or by any means, electronic or mechanical, without the prior written permission of the owner. Copyright © 2018. For a list of references, you can contact the author via [email protected] or [email protected] Investment • How people manage their wealth? 3 Investment history • Code of Hammurabi(1700 BC) provided a legal framework for investment by codifying debtor and creditor rights. • First venture investors: maritime expeditions were first case; navigators were the most adventurous entrepreneurs, and ship owners were first VCs. • Why investment emerged? Because of specialization; some people have expertise without capital. Some other people have capital, but not enough time or expertise in lucrative fields 4 Traditional Investment vs. VC • The main difference is between Risk & Reward • Risk factors in ventures are: • Innovation risk • Business model risk • Operation and scale up risk • +90% of Ventures have no earning for investor • VC is a Knowledge-base investor, you need to be expert in some fields. • So, you can help out and control management. • Also, you are doing something unique, so it has social impacts and personal identity 5 Risk in traditional company vs. digital company Relative weight of technological risk and marketing risk, as company grows 6 Why VC emerged in 20 century • In the past, Information from inside company could not effectively communicate to outside; so investors didn’t know what they are investing in. • It was very risky to take an equity stake in a company; Limited liability made it possible. So, investors are not liable for company default. • Before these two, lending money was much safer than buying shares for investment. 7 VC timeline Georges Doriot (the father of venture capitalism) started First VC: ARDC (American 1946 research and development corporation) after world war II The first star: 70K$ investment in digital equipment corporation in 1957 valued more 1968 than 355M$ in 1968 (101% annual rate) after IPO Small business act; licenses private companies to finance other businesses in US and 1958 gave tax breaks to them US labor department removed some restrictions, allowing corporate pension funds to 1978 invest 10% of their funds in venture funds, providing a major source of capital available to VC (the industry became ~40X) 2003 Dot-com bubble have shriveled industry to about its half 8 Venture capital fund raising in the U.S. 1985-2015 9 Upside & downside in investment • Risk means you have the possibility of losing some, or even all of your investment. • In investment, usually risk and return are tradeoffs. (two sides of a coin) • Some people are risk averse, and some others are risk seeker. • The person who refuses a fair bet is risk-averse Example: Lets Flip a coin; which option do you choose? • You will receive 1MT without flipping coin • Or you will receive 2MT if heads • Which one does VC choose? 10 Salesman case study An ordinary man with fixed 15K$ salary in a job with no certainty • A proposal comes: a salesman commission-based job with 30K$ (upside) if works well, and 10K$ (downside) if result are not good • probability of good and bad result in salesman mind are same, 50% • So, will you take the proposal? Like any other answer in management, It depends. 11 Salesman solution The utility function is: E (U) = 0.5 U (10,000) + 0.5 U (30,000) • So, the answer depends on each person utility and attitude to risk. • The utility for risk seeker is 60, (more than 43 in 20K$), so he takes job • and for risk averter is 37.5 (less than 65 in 20K$), so he refuses. 12 Liquidation When you can liquidate your investment? Simply “cash out” 13 Liquidation and Exit • Liquidation: a process by which a company is brought to an end, good or bad • Exit: when an investor gets a return on their investment in a venture-backed startup • Different types of exit: • Acquisition • Acquihire • Merger and acquisition • IPO • Not selling the startup • Investors are looking for a return of 10-100 times on their original investment 14 Acquisition and Acquihire • Acquisition: • Buyer takes over startup using cash or stock as a compensation • Team usually stays at company for a period of time to cash out and vest their stock • One example is: Waze, acquired by Google in 2013. The technology is used in Google maps for estimating traffic . • Acquihire: acquisition + hire • Buyer usually is more interested in team, than product • Often leads to closure of products, or change the direction of product 15 Linkedin timeline; IPO and acquisition case 2003 Raised 4.7 M$ in first year 2008 Raised 53M$ with valuation 1b$, joining unicorn club. 2008 Raised 22.7m$, more than 100M$ in total funding 2011 Went public, the record market cap was +20b$ in 2015 2016 Acquired by Microsoft with 28B$ valuation 16 Number and value of M&A worldwide 17 IPO • IPO: (initial public offering): When raising more capital from VC or private equity firm is no longer an option, let’s go for IPO Number Number of IPO in U.S. 18 M&A and Not selling the company • M&A • Merging with similar or a larger company • Often chosen by big companies looking for complimentary products. • Not selling the company, milking the cow: • When you can establish a solid business model and revenue • You invest your profit in your company • part of those profits can also be distributed amongst investors as a dividend Further reading: The hard thing about hard things; a real story of ups and downs in IPO and acquisition 19 Liquidation in Iran • Some challenges: • There are not many large IT companies in Iran. So no one acquires your startup • The IPO process is not well-known among startups, because success stories are few • Interest rates are higher, so investors cant wait until you make your own profit • Some cases of liquidation in Iran • App (*733#): went public on 1395, now market cap is around 3700bT • Zoodfood: acquired by rocket in 2014, merged with bodofood, to accelerate partnership with restaurants • Fidibo: acquired by digikala, to offer customers both physical book and ebook 20 Investment rounds 21 Investment rounds • Seed investment: a preliminary investment for an idea • Series A: when you have a strong defined idea • Series B: when you truly established your business • Series C and beyond: no technical limit 22 Investment rounds • Seed investment, to achieve: • Product identification • Marketplace orientation • Customer targeting • Team creation • Series A, to achieve: • Build Distribution channels • Pay for marketing • Develop new markets 23 Investment rounds • Series B, to achieve: • Team expansion • Globalization • Acquisitions (if needed) • Series C and beyond: • There is no technical limit, mainly it is related to market expansion and growth rate • Be aware of anti-dilution agreements, which prevents founders stake to water down Further reading: - infographics in funders and founders - Company profiles in crunchbase 24 25 26 Bibliography • A brief history of venture capital; https://www.financialpoise.com/a-brief-history-of-venture- capital/ • Why venture capital thrives in digital world; https://salon.thefamily.co/low-risk-high-reward-why- venture-capital-thrives-in-the-digital-world-ed56d0b14dc • Utility theory and attitude toward risk; http://www.economicsdiscussion.net/articles/utility-theory- and-attitude-toward-risk-explained-with-diagram/1384 • How can startups exit and investors make money; https://startupxplore.com/en/blog/exit- strategies-for-startups-and-investors/ • Startup Investment 101: Investment Rounds Explained; http://blog.onevest.com/blog/2015/4/23/startup-investment-101-investment-rounds-explained • Intellectual property strategies for startups; https://techcrunch.com/2016/10/31/intellectual- property-strategies-for-startups/ • Silicon valley venture survey; https://www.fenwick.com/publications/Pages/Silicon-Valley-Venture- Survey---Second-Quarter-2014.aspx 27 Shareholder Agreement How to make a deal Definitions • Letter of intent: It says that we have accepted idea, team and value proposition • Term sheet: a non-binding agreement that sets forth the basic terms and conditions under which an investment will be made • Shareholder agreement: • A shareholding agreement is the final document. • It is definitive and legally binding. • It outlines the shareholders' rights and obligations. • It depicts how company operates. • SHA should be fair, and should be perceived fair, unless, the company will get locked, because founders or investors will not be interested enough to continue this hard journey. • Shareholder agreement has different characteristics. 29 Basic types of investor funding 1 Equity investor will receive a stake in exchange for money Loan 2 you borrow money now, and pay it back later Convertible debt 3 a mash-up of debt & equity Question: Which one is suggested for startups? 30 Equity • Investor will receive a stake in exchange for money • When to do it: • When you need a long runway • When you have zero collateral • When you can’t possibly bootstrap • When you are positioned for astronomical growth • Things to keep in mind • Equity narrows your options: because equity investors are interested